​​​Setting key policy rates at negative levels has become common practice for major central banks in developed economies. According to the European Central Bank, around 18% of the global economy weighted by GDP operates in an environment of negative central bank rates. This proportion rises to 40% when countries in the 0 to 1% range are included.

The rationale behind low and negative interest rates is that banks are incentivized to lend to companies and households instead of hoarding excessive reserves at their central banks. But negative rates may have adverse effects on financial stability. Banks' profitability is negatively impacted which may encourage excessive risk-taking and foster asset bubbles. Insurance companies and pension funds will also face serious problems in meeting their long-term liabilities at a fixed nominal rate.

While the majority of financial institutions are suffering from the current interest rate environment, negative effects may even be higher depending on the bank's profile. Because of their specific features and of their business model, savings and retail banks are particularly exposed.

The specificity of retail and savings banks and negative interest rates

Savings and retail banks in Europe have always been strong in the provision of retail services to households and SMEs. Savings and retail banks provide more loans to the real economy than commercial banks. Their business model is centered on the transformation of local savings into loans to their retail customers which is reflected in the higher share of outstanding loans to clients granted compared to total assets.

Retail banks are particularly exposed to low/negative interest rates

Since savings and retail banks get a large share of their income from interest on loans to customers, they are mechanically affected by any downward trend on loan interest income. On the other hand, to preserve their level of profitability, banks may benefit from the same downward trend on deposit rates thus keeping their net interest margins at similar levels.

Negative interest rates make this strategy quasi-impossible for savings and retail banks. Banks may be hesitant to pass on negative deposit rates to their clients and regulatory frameworks in the EU may hinder or restrict any possible attempt of bank's management teams to opt for a strategy of passing on negative interest rates on their customers.

The maturity mismatch between assets and liabilities is particularly severe for savings and retail banks as a large share of their portfolio is driven by mortgages which are typically long in maturity. On the liability side, retail deposits are liquid since these are primarily made up of savings accounts and other short-term liability products.

Consumers are on the front line when it comes to the low interest rate environment. If interest rates go down, the reward from saving falls. It becomes relatively more attractive to hold cash and/or spend. This is the substitution effect – with lower interest rates, consumers substitute saving for spending. However, if interest rates fall, savers see a decline in income because they receive lower income payments. A pensioner relying on interest payments from saving may feel they need to save more in order to maintain the income from savings.

On average, across European countries, the household savings ratio has continuously plunged every single year from 2009 (13.2%) to its lowest point in 2014 (10.3%). While countries with a strong savings culture, such as France or Germany, have remained relatively stable, the decrease has been spectacular in some other countries such as Spain or Italy, respectively losing 38bps and 30bps to reach 9.7% and 10.5%. Putting aside factors such as the weak developments in real disposable income or high unemployment, low interest rates are directly pointed out by the ECB in its Economic Bulletin[5] as an explanatory cause for these low savings rates.

From a retail banking perspective it should be central to the debate that the savings and retail banks are traditionally the banks for savers on the liability side and for loans to SMEs on the assets side. Together with the longstanding and trusted relations with a significant customer base, savings deposits are at the heart of these business models. Staying profitable and successful in the negative interest rate environment creates important challenges that might endanger these longstanding business models. Forcing financial institutions that are inextricably linked to the economic fabric of Europe to go into uncharted territory to remain profitable would increase the risk profile of these same financial institutions unnecessarily.